The relationship between interest rates and exchange rates can be represented th

Question

The relationship between interest rates and exchange rates can be represented through the concept of interest rate parity. Consider the following: An American investor is considering investing dollar 1,000 in default-free 90-day Japanese bonds that promise a 3 percentage annual nominal return. The spot exchange rate is ¥104.79 per dollar. The 90-day forward exchange rate is ¥103.55 per dollar. What would be the investor's annualized return on these bonds if he or she can lock in the dollar return by selling the foreign currency in the forward market? 8.998 percentage 7.824 percentage 6.259 percentage 7.433 percentage

Explanation / Answer

The investment in the bond(in $)=$1000

The investment in the bond(in Yen)=$1000 * (104.79) Yen/$

The investment in the bond=104790 Yen

The value of the investment after 90 days in Yen=(1+0.03*(90/360))*104790 Yen

The value of the investment after 90 days in $=(1+0.03*(90/360))*104790 Yen *(1/103.55)($/Yen)

The value of the investment after 90 days in $=(1+0.03*(90/360))*104790 *(1/103.55)

The value of the investment after 90 days in $=$1019.56

Therefore annual dollar return=((The value of the investment after 90 days in $/$1000)-1)*(360/90)

Therefore annual  dollar return=((1019.56/1000)-1)*(360/90)

Therefore dollar return=7.824%

Therefore the investors's annualized return on the bond is 7.824%.

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